Unitary elasticity of demand is a situation in which the price change affects the quantity demanded at an equivalent percentage. For example, when the price of a good rises 3%, the quantity demanded decreases by 3%. And, when the price drops by 3%, the quantity demanded increases by 3%.
Before discussing further, let’s recall the own-price elasticity concept.
Own-price elasticity of demand shows you how responsive the quantity demanded an item when its price changes. You can calculate it by the following formula:
Own-price elasticity of demand (OPE) =% Changes in the quantity demanded of the Good X /% Changes at the price of the Good X
From the value of OPE, you can classify goods into three groups. They differ in terms of their sensitivity to price changes. Goods are
- Elastic, when the absolute value of OPE (or | OPE |) is more than 1. When prices change by 3%, the quantity demanded changes by more than 3%. You can say the demand for goods is sensitive in response to price changes.
- Inelastic, when | OPE | less than 1. When the price changes 3%, the quantity demanded changes less than 3%. That means demand is less responsive to price changes.
- Unitary elastic, when | OPE | = 1. A price change of 3% changes the quantity demanded by 3%.
Why should you know the concept of unitary elastic?
Knowing the elasticity of demand helps you in pricing. The concept helps answer the question, will raising prices lead to higher income?
The answer to this question depends on how elastic the product demand is.
Please note. Total revenue is equal to the price times sales volume (demand).
- When demand is elastic, raising prices will decrease total revenue. Increasing the selling price by 3% reduces the quantity demanded by more than 3%. As the percentage decrease in the quantity demanded is lower than the percentage increase in the price, total revenue decreases.
- When demand is inelastic, raising prices raises total revenue. When the price goes up by 3%, the quantity demanded falls by less than 3%. Therefore, total revenue will increase because the percentage increase in price is higher than the effect of decreasing quantity demanded.
- When unitary demand is elastic, a higher price is unchanged total revenue. An increase in price by 3% will cause a decrease in quantity by 3%. So, overall, total revenue is still the same.
The opposite effect applies when companies lower prices. A fall in prices increases total income when demand is elastic. That decreases total revenue when demand is inelastic. And for unitary elastic, total revenue doesn’t change.
How to increase demand under such conditions?
To increase total revenue by raising prices, companies should make product demand relatively inelastic. One way is by differentiation.
Differentiation reduces the level of substitutability of the product. This strategy makes the product unique, making customers willing to pay more. Also, the uniqueness makes consumers challenging to find the right alternative products.
When successfully differentiating products from competitors’ offers, the company can raise prices. And, customer demand is insensitive to a higher price. As a result, total revenue goes up.
In general, demand will tend to be inelastic when substitute products are unavailable. Take, for example, diabetes medications. Diabetes demand will remain despite rising drug prices. That’s because even though the price of the drug goes up, the patient still needs diabetes medication. If it is unavailable, it increases the risk of patient death.